Just like you maintain an emergency fund to protect yourself from disaster, companies need to have cash on hand to pay their immediate expenses. If they don’t have enough liquidity, they will struggle to operate and fail to find credit for emergencies.
Before you decide to add a company to your investment portfolio, you should measure whether it has the ability to pay its expenses. A simple way to calculate liquidity is the quick ratio.
What is the quick ratio?
The quick ratio measures a company’s ability to meet its current liabilities using only its most liquid assets. Highly liquid assets—also called _quick assets—_are assets that can be converted to cash quickly.
The quick ratio is used as an indicator of a company’s financial strength. Lenders and investors use it to determine how quickly a company could pay its debts under the worst possible condition. If the company has enough easily accessible assets to pay its bills, it probably won’t need to sell off more valuable assets in an emergency. And if it ever needs credit, it won’t have trouble finding a lender.
A quick ratio of one or greater indicates healthy liquidity because the company has plenty of assets that can be converted to cash quickly if necessary. Investors like a healthy quick ratio because it means the company is more stable and less likely to fail. Creditors like a good quick ratio because it assures them they’ll be repaid on time.
However, it’s not a good sign if a company’s quick ratio gets too high. A high quick ratio means there’s a lot of cash sitting around. That money should be invested in revenue-generating activities or repaid to investors. Stagnant cash doesn’t help anyone.
Since the quick ratio indicates a company’s ability to instantly pay current liabilities with cash or near-cash assets, you’ll also hear it called the acid test ratio. An acid test is a quick test that produces instant, incontestable results.
How to calculate the quick ratio
Featured Snippet: Quick Ratio Formula Calculate the quick ratio by dividing the sum of highly liquid assets by the company’s current liabilities.
Calculating the quick ratio is simple. Any investor can do it using data they find on a company’s balance sheet. You simply divide the sum of quick assets by the company’s current liabilities.
Quick Ratio = Quick Assets / Current Liabilities
Notice that we aren’t concerned with all assets or all liabilities. We only want quick assets and current liabilities.
Quick assets
Quick assets are cash (already as liquid as it gets!) and other assets that can be converted to cash within about 90 days without compromising on price, such as cash equivalents, securities that can be sold immediately on the market, and current accounts receivables. While you can sell anything quickly if you’re willing to drop your price low enough, an asset is only a quick asset if you can sell it quickly at its actual value.
Inventory (raw materials, components, and finished products) is rarely considered a quick asset because businesses typically have to offer deep discounts to move it quickly. Industries where inventory tends to move fast are exceptions, like retail or fast food.
Accounts receivables are only considered quick assets if the company can collect in 90 days. If a company lets customers pay over time, only the portions they collect within 90 days are quick assets.
Current liabilities
Current liabilities are financial obligations that need to be paid within a year. It includes accounts payable, short-term loans, payroll taxes, income taxes, wages, dividends declared, accrued expenses, and the current portions of long-term loans. It doesn’t include items like commercial mortgages.
Quick ratio example
Let’s unpack a fictional company to help you understand how the quick ratio works.
Acme Widgets wants to take out a loan to finance the launch of a new product. It would rather pay the interest on a loan than spend its cash on hand. The bank asks to see the company’s balance sheet, which includes the following accounts:
Cash and equivalents: $26,000
Accounts receivable: $4,500
Marketable securities: $5,600
Inventory: $9,200
Prepaid insurance: $1,800
Current liabilities: $21,000
To find the company’s quick ratio, we first need to total its quick assets. Acme Widgets cannot sell through its inventory in about 90 days, so we don’t include that account. We also won’t include prepaid insurance because the company can’t get it back within 90 days. Once we determine quick assets, we divide them by current liabilities.
Cash and equivalents ($26,000) + Accounts receivable ($4,500) + Marketable securities ($5,600) / Current liabilities ($21,000) = 1.7
A quick ratio of 1.7 means Acme Widgets can pay off its current liabilities with its quick assets and still have a little remaining. The bank will find this encouraging because they know Acme Widgets will always have a way to pay them back.
Quick ratio vs current ratio
The quick ratio is similar to the current ratio in that it measures a company’s ability to pay its liabilities with assets. However, the current ratio calculates all of its current assets, not just the ones quickly converted to cash. A current asset is any asset that can be converted to cash in about a year.
For instance, the current ratio would consider a company’s inventory as an asset because it can be sold for cash to pay expenses. In most cases, however, the quick ratio would not consider inventory because it would take some time to liquidate.
Since the quick ratio considers fewer categories of assets, it’s always lower than the current ratio. This makes it a more conservative metric. Think of it like making two versions of your household budget: One that includes your part-time job income and one that doesn’t. The budget that excludes that extra income will be more conservative.
Is one ratio better than the other? Not at all. Investors and lenders use both to evaluate companies. Just make sure to consider context during your evaluation. For instance, a restaurant will have a lot of inventory on hand. Since inventory isn’t used to calculate the quick ratio, the restaurant will appear to have few quick assets. In this case, it makes more sense to rely on the current ratio.
Uses & limitations of the quick ratio
Since the quick ratio compares the dollar amount of a company’s highly liquid assets against the dollar amount of current liabilities, it gives you a brief overview of a company’s solvency. Essentially, it reveals how vulnerable it is to catastrophe and how likely it is to invest in new growth.
If a company’s quick ratio is less than 1, it doesn’t have enough liquid assets to pay its current liabilities. This kind of company is in a dire position. A sudden expense or a downturn in sales could wipe out its quick assets and force it to sell non-liquid assets. Since most companies generate revenue through their long-term assets (equipment, machinery, vehicles, real estate, etc.), selling these items could impact its ability to make money in the future.
If a company’s quick ratio is exactly one, its quick assets equal its current liabilities. This company could pay its liabilities if it sold all of its quick assets. Presumably it would have some non-liquid assets left over, so this isn’t an especially dangerous position. Nevertheless, it could use improvement.
If a company’s quick ratio is greater than one, it has more quick assets than liabilities. It can safely pay all of its short-term liabilities if it had to without sacrificing any of its non-liquid assets. This is a healthy position and a prize for investors and lenders.
What’s a good quick ratio?
Generally, quick ratios between 1.2 and 2 are considered healthy. If it’s less than one, the company can’t pay its obligations with liquid assets. If it’s more than two, the company isn’t investing enough in revenue-generating activities.
Keep in mind, however, that the quick ratio isn’t the full picture. You should always consider context. There are plenty of valid reasons a company might have a high or low quick ratio. Quick ratios can also change over time, as well, which is why many companies target a range rather than a specific number.
For instance, a company may try to keep its quick ratio between 1.3 and 1.6. If it falls below 1.3, they’ll reduce liabilities. If it rises above 1.6, it will spend some of their assets on new revenue activities.
Furthermore, you’ll see different quick ratio patterns across different industries. The technology sector almost always boasts healthy quick ratios. Companies in the energy sector, however, are notorious for having small quick ratios—some as low as 0.2!
The bottom line
The quick ratio is a valuable way to measure the short-term health of a business. If you like to pick your own stocks, you’ll want to add it to your investigatory toolbox. Calculate it whenever you consider investing in a new company, just make sure you understand context. If you aren’t comfortable buying stocks, consider automated investing or a high interest savings account.
